THE BIG FIVE, NAHMEAN

There are five numbers that we have to look at to determine whether a business has a Moat. Moat, of course, is some sort of protection by which a business automatically wards off competitors. Protection comes in a lot of flavors. Some bad boys protect their urban businesses with tech nines, nahmean. But we don' be investin' dere, bro, nahmean? We gonna move up to a better class of management that does their fighting with their brains, not their bullets. It's a lot safer and has a much more consistent success rate. So we wantsome sort of Brand (when you want a Coke, a Pepsi just won't do), Secret (patents and trade secrets), Switching Cost (too much hassle & expense to switch from Windows to a Macintosh), Toll Bridge (can't advertise to all of Washington, D.C. without buying ad space in the Post), or Low Price Moat (Walmart). Any of these offer protection without a lot of fighting. No tech nines. Just an occasional lawyer. The Big Five numbers are a clue that there is a big Moat in place. And if the Big Five are bad, ain't no moat, bro. You want to defend that castle you better count your ammo, nahmean? The Big Five are just: 1. 2. 3. 4. 5. Return on Invested Capital (ROIC); and the growth rates for EQUITY EPS SALES FREE CASH

We want to see all of these at 10% or better and not dropping. Of these ROIC (you can also find it here on MSN) and Equity growth rate are the most important. ROIC tells us that the CEO is handling the most important thing a CEO can do - wisely investing the surplus from profits. If ROIC is below 10% or is dropping, run away. It's a sign the CEO is more interested in building an empire than giving the owners a great return on their investment. Equity is the surplus from profits. We love to see steady equity growth,especially if the business is not giving back some of the equity to us owners (thats called a dividend). We love a business that can use all that surplus to grow and it keeps the ROIC high. That, my friends, is an awesome business. (More on how to calculate this growth below.) And then we want to see EPS and SALES and FREE CASH growing at around the same rate as EQUITY. And we want to see them linear and consistent. By that I mean they go straight up, not bouncing all over the place, and the growth rate is consistent across the years.

I usually look at 10 years, 5 years, 3 years and 1 year. The idea is to see first if they are high enough long term and then if they are improving or falling. We want 10% or better and holding steady or improving. If you are using a pro toolset like Success, most of this is done for you with the Trend tool. But you can do it in your head with a little practice. Remember the Rule of 72 post? I use the Rule of 72 to do these in my head all the time. For example, go to MSN.com Money, select a stock, click on Financial Results, Key Ratios, Ten Year Summary and you'll see a column for 'Book Value /Share." That's EQUITY broken into per share pieces. Here's a picture of Whole Foods: (click on it to see a larger view)

Using the Rule of 72 I start with the oldest number in the column: $3.82. That's about $4. So I double 4 once to 8. Then double it again to 16. That's pretty close to the highest number, $15.84, so I stop there. Two doubles in how many years? 96-97 is one year. And so on. I get 8 years. 2 doubles in 8 years means one double in 4 years. 4 into 72 is 18. So the equity growth rate at WFMI is 18% for the last 8 years. How about the last 5? A bit better. Call it 20%. And 3? About 24%. And last year? Well, that's when it's nice to have an automatic tool. But you can do an Excel calculation if you want that last number. I did it. Here it is:

The one year bvps growth rate is 23%. Wow. This is what we look for . An accelerating growth rate above 10%. Sweet. Go do that for all of the Growth Rate numbers, and if they're all that consistent, you got moat, nahmean.

HOW TO SET UP EXCEL FORMULAS

I've had a lot of emails come in asking how to set up formulas in Excel. (Here's a link to an online Excel tutorial for beginners.) Basically, we can use Excel formulas for figuring out three things: 1. The future EPS 2. The future value per share 3. The present value per share (or what I call the Sticker Price) Start by collecting three ingredients (just like baking a cake): 1. Current twelve month EPS - (On investools it's automatically on the valuation page. On MSN Money go to company report and find it on the list of stuff.) 2. 10 year average PE (or 5 year) - (On investools it's automatically on the valuation page. On MSN Money go to Financial Results, Key Ratios, Price Ratios.) 3. Estimated EPS growth rate - (On investools the analyst estimate is automatically on the valuation page. Change it if you think it's too high. On MSN go to earnings estimates, earnings growth rates and you'll see the analysts' average estimate. Use a lower one if it's too high.) Using the Excel =FV formula -- which you get by selecting a cell and typing =FV( -- you are asked by Excel for these things: =fv(rate, nper, pmt, [pv], [type]}

For rate put in the estimated growth rate as a percentage, like 20%. For nper put in 10 (for ten years) For pmt put in nothing but leave the comma. For [pv] put in the current TTM EPS with a minus sign in front and no dollar sign, like this: -1.04 Hit enter and it will calculate the future EPS out ten years.

Now you have to calculate the future stock price out ten years using the future eps and the PE you decided on. Use whichever is lower, the historical PE you got, or 2 times the growth rate you used above. Multiply the future eps by the PE and you get the future stock price out ten years.

Now calculate the present value or Sticker Price (retail, intrinsic value, 'what it's worth', etc.) For this calculation you need the future stock price and the Minimum Acceptable Rate of Return (which for me is always 15%). Using the Excel formula =PV() you'll need to plug in the following:

rate - Minimum acceptable rate of return - 15% nper - 10 (to bring the future back to today, since we went ten years out) pmt - skip but leave the comma [fv] - the future stock price we got as a negative, like this: -88.43 [type] - skip Hit enter and you'll get the Sticker Price.

Since I use 15% and 15% always compounds with two doubles in ten years, I can do this Excel step in my head. I just divide the future stock price by 4. So for me, if the future stock price is 88, I immediately see the Sticker is $22. Try it with the formula and you'll see what I mean. The answer will be the same either way. Final step: Divide the Sticker by half and you get the MOS. Margin of Safety. And you're done. CAUTION: This is ONLY to be relied on if the business isPREDICTABLE (which means it has meaning, moat and management) from demonstrated CONSISTENCY AND DURABILITY. Otherwise you're just playing head games. And thank God for great technical tools that track the big guys moving big money. Don't forget to watch and respond. And in no case should you become so convinced in your superior analyzing skill that you ignore what's going on in the market. Remember that the big guys know way more than we do about any business we're investing in and will take action to get out if something is going wrong -- something that the general public hasn't sniffed out yet. When they start leaving the theater it may be because they're smelling smoke -- and you'd best depart with them if you don't want to burn.

THE RULE OF 72
Here's a question I get asked every day, and an answer I think will help everyone doing a 4M company analysis. How do you calculate the equity (or book value per share) growth rate? (And I'll expand that to include sales, EPS and cash growth rates.)

I'm going to teach you how to do this in your head. Once you learn it you will understand why Warren Buffett doesn't need a computer to figure out whether he likes a business or not. Here's how: MSN Money reports book value per share numbers for 10 years in a column under Financial Results - Key Ratios - 10 year summary. Investools puts up ten years of balance sheet info under Fundamentals - Balance Sheet. Others do it similarly.

Start with the oldest number (and of course don't even bother unless the growth is consistent -- but at this point that goes without saying, right?), round it off to something that is easy, and double it in your head. Keep doubling until you get to a number that is as high as the most recent equity number. How many times did you double it? Let's say you doubled the oldest number two times. Now divide two into the number of years from the oldest to the most recent equity number. On the sites I use, it's usually 9 years. Two goes into nine 4.5 times. 4.5 is the number of years it took for the equity to double once. This next bit is called The Rule of 72. When you divide the number of years it takes to double your money into 72, you get the growth rate. For some unknown-to-me reason this actually works. 4.5 into 72 is about 16. Ballpark. So the equity in this example is growing at 16% a year for the last 10 years.

I use the Rule of 72 all the time. It isn't perfect but it's quick and doesn't require a calculator. Here's a real world example from EXBD using data from MSN Money: Book value per share in 1999 (the oldest number) is .40. In 2004 it was 8.41. Start doubling .40. double once to .80. Double twice to 1.60. Double three times to 3.20. Double 4 times to 6.40 and then part of a double to get to 8.41. I look to see the number of years. 19992000 is one, and so on. I get 5 years with 4 doubles. That's a double almost every year. Divide 1 into 72 and you get 72. So EXBD has a book value per share compounded growth rate of 72% for the last 5 years. That's crazy but it happens to new, fast growing businesses. Let's do it again more recently and see how they're doing: In 2001 their BVPS (Book Value Per Share) was $4. Now it's $8. So in three years (2001-2002, 2002-2003, 2003-2004) they doubled their book value per share. 3 years to double once. 3 into 72 is 24. So more recently their BVPS is growing at 24% a year. Still phenomenal. And how about 2003-2004? it went from 6 to 8 bucks. Thats up $2 in one year starting from $6. If they keep up that growth ($2 a year or so) then in three years they will have doubled the $6 again - probably a bit faster than 3 years. So recently they're still growing equity at 24%. You gotta love the rule of 72 for quick and dirty calculations. After a while, you get to where you can just glance at the numbers and see consistency -- and then quickly do the doubles on the

oldest number and see if the equity growth rate is high enough to make this a business worth considering. No computer required.

WHEN TO RE-DO THE BIG 5 NUMBERS

When should you re-calculate the numbers... and when should you decide that your Wonderful Business has become Un-wonderful? Every business that has stock in the public markets is required by the SEC laws to file a quarterly report. The quarterly report filing with the SEC is called the 10-Q... Q for Quarter. The annual filing is called the 10K. K for... whatever... Kilo. Oh. There's the old guiding days sneaking back in. The 10Q's come out at various times because not all businesses are on a calendar year. However, a lot of them are, which means that the end of the year is December 31 and the end of the first quarter is Mar 31. The numbers, however, do not come out on March 32. The accountants have to get all the numbers and do an audit and certify them and then get the CEO to sign off that the numbers are real, and all that takes some time. The 10Q's come out a few weeks after the end of the quarter. When the 10Q comes out publicly, the data collection companies get copies of the report, then load those numbers into their databases for uploading to the various businesses that provide the data to the industry and public. Some of the sites, like MSN Money and Yahoo, are free and provide a limited set of data. Others like Investools charge for the data and typically provide more data in a more easily managed format. The key thing to note is that each quarter, you get a little look at how things are going for your business. You can see if they exceeded the expectations of analysts or if they did not. And you can, at that point, recalculate the Big Five (or just look them up on some sites). If you see that the Big Five are suddenly inconsistent with the past (one or all), it is time to ask yourself a question: Do you know what the problem is? Likely, if you are like me, you do not know. Also likely, if you are like me, that you got three red arrows before you ever saw the report in the first place, and you are now in cash.

The reason for that likelihood is that the institutional investors believe that the only way they can make money on a stock is to have information that none of the other institutional investors have. For that reason, key people in corporations are courted like royalty. They get dined and wined and taken to the Superbowl. And in exchange for this personal relationship, the institutional manager hopes to get wind of something -- good or bad -- before any of his peers. Seldom happens. Most of his peers are as up on whatever is going down as the next guy. And that is why, two weeks before Meg Whitman announced that EBAY was NOT going to grow as fast as everyone was expecting, that the stock had sideways price and two red arrows. And all of us red arrow followers were out. And then she announced. And the stock dropped 30% almost overnight. So two things. Watch quarterly for the numbers. Act as if this is your only business. If the numbers change suddenly and you don't know why, don't go back in until you do know why. How do you find out why? Listen in on the next analyst phone call. They post them on the website of most good businesses so you can do just that even if you weren't available that day. Listen to the call. The analysts will ask all the hard questions. Listen to the answers. Sometimes it's a good answer that makes good sense. Sometimes they are dancing. The difference isn't all that subtle. After Apollo Group's CEO suddenly quit, an analyst asked what happened. Something all of us wanted to know. The acting CEO said "Read the SEC filing." That was real subtle. Time to say bye-bye to APOL until the dust settles and the real story comes out.

QUESTION OF THE WEEK: DAILY VS. WEEKLY CHARTS

This week's question comes from James, and is about how to read the three tools described in Rule #1. Question: Hi Phil Town, I have a question about your book. On page 210, the 3 charts show when to buy and sell Starbucks. I tried to duplicate the charts on the web, and they match if I select the weekly (instead of daily view). However, the buy and sell trigger points are very different between the daily and weekly charts. For example, the daily chart show all 3 buy signals on 9/2 and all 3 sell signals on 9/22. The book and my weekly chart show all 3 buy signals on 9/20. Why the discrepancy? Should I use daily or weekly charts? Thanks,

James R. Answer: Hi James, When you shift from daily to weekly charts, the inputs change from days (8 days, 17 days, 9 days) to weeks (8 weeks, 17 weeks, 9 weeks). That creates a whole different chart. I recommend you use the weekly chart inputs for long term situations since the signals to get in or out are going to come much more slowly than with daily charts. An example of that sort of situation would be when you have money in mutual funds in a 401K that can't be moved so quickly. You use the tools with a weekly data input mostly so that you'll get out in the event of another market melt-down, but you don't have to get in and then out a week later as you might with a 'faster' toolset. Ahhh. And there is more: When a business splits its stock like SBUX did, the changes in price sometimes change the historical chart. I'm not sure why this happens since theoretically it shouldn't, but it does. Perhaps it's because some charts have smoothing built into them that changes them historically. In other words, what you see today may not be exactly what you see in 3 years. Such is life. And yet another reason that I tell you guys that you won't make money with tools. You make money by buying a wonderful business at an attractive price. Tools just help you keep from losing it in a crash and help take the fear out of investing.

How Important is Market PE?; Applying Tools to the Market; and Where to Put Cash
Three interesting comments were posted to the blog over the past week, and I answered them tonight. I'm re-posting them here so you can all see the answers. 1. From Dom, re: "Predicting the Market": If we can use the tools to see what the big boys are doing and predict stock prices, why can't we do that with the stock market? If we know that the PE of the market is generally 10, shouldn't we be able to buy when it is less and we have 3 arrows? Also, should we continue to use a PE of 10 or should we consider bumping it up like we do for our future sticker prices? Basically, if we know that a good company is going to grow at its historical rate, couldn't we also say that the markets will grow at their historical rates? If so, couldn't we use the tools to predict them the same way we predict stock prices? Phil Town's response: You make a good point. First, though, the market averages a PE of about 15, not 10. A market PE of 10 is low. The problem with relying on a market PE is the same problem we have relying

on a PE for a business. I wish it was that simple but it isn't. PE's reflect expectations of growth. Thus a company with a high PE might be a lot cheaper in the long run than one with a low PE, depending on what you pay for it. When we look at the whole market, all we can do is make the reasonable assumption that in the long run the market is going to do well. By 'long run' I mean over the next 20-30 years. America is competitive. Our businesses are competitive with the world, so things should hold up well in the long run. That's our general philosophy. So when I say that you can load up the truck when the market PE is low -- like under 10 -- I only mean that in the most general sense. You still have to determine that the business is durable, that management is wonderful and you understand the business well enough to buy it in the first place... and then that it has a big margin of safety. In effect, the price of the entire market is only relevant in the sense that it is more likely that great businesses will be on sale in a market with a PE of 10 than in one with a PE of 40. So don't take any shortcuts and don't rely too much on the 'market' price. 2. From hurdler52, on the same post: My question has to do with the tools (tech. indicators). Should we apply them to the market before applying them to the individual companies, or does it even matter? My response: I think it makes a lot of sense for a small investor to watch the market as a whole with market indicators like the SPY, DIA & QQQQand others. There is an old saying that 'the trend is your friend'. It is very difficult to time the market and do well, so we don't really try to do that. But we do look for the general trend and try not to buy companies when the trend in the whole market is down. It also pays to look at the trend in the industry that you are buying into. Again, it's just an indicator and not the final arbiter, but if the market trend is down and the industry trend is down, it is very hard for a good business to make price headway into that strong of an emotional headwind. Essentially those down trends are created by the Big Guys, and it's Big Guy money being poured into your business that makes it go up in price. If they aren't doing that, the price at best isn't going anywhere. So yes, watch the big indexes to get an idea of the general trend. That's the sort of thing I'm looking at when I tell Maria Bartiromo that when the big guys are leaving the market, it's time for the little guys to leave, too. 3. From Nozzy, re: "Cash is Good Until You Are Sure":

I understand the old saying, "Cash is King". I am a new Rule #1 investor, and am currently working on my list of wonderful companies. In the meantime, when staying in cash, where would be the best place to put it? I have read a few posts on this topic, but would like a little more input. I appreciate any and all of your help. This is a great website and blog. I have learned a lot just by reading all of the posts. Thanks to Phil and all Rule #1 investors. My response: Cash can sit anyplace safe that's paying some sort of interest. An insured brokerage account is the most convenient if you have enough of it that the broker is willing to pay a money market rate. BusinessWeek says the following: "Some brokers have a tiered interest rate system that depends on your account size. On balances of $10,000 or more, for example, Interactive Brokers pays 4.8%. Accounts with less than $10,000 earn nothing. At Scottrade, $1 million accounts get a 4.3% yield, while those with under $1,000 earn only 1.8%. Whichever broker you choose, ask about how cash is treated. At Muriel Siebert, T. Rowe Price, and Vanguard, for instance, cash automatically goes to a money market fund. At others, such as Schwab, E*Trade, and TD Ameritrade, you need to specifically instruct the firm to sweep your cash into a money market fund. Otherwise it will sit in a cash account, with the yield determined by the firm, not the market. Those yields may be only around 1%."

Predicting the Market

Phil Town response:

got this comment on the blog recently, and wanted to make a

I missed most of the last 5 year bull run because I have been waiting (and waiting ...) for the Big Correction to come. By ignoring the Rule # 1 indicators (which will still say BUY from time to time), couldn't I just be setting myself up for missing another 5 years of possible growth ... ? Thanks, Adrian

Keep in mind that we are not so good at predicting the market as a whole. When I talk about the market at a 10 PE, I only mean that it gets there from time to time and it's way overdue. HOW it gets there is another story altogether. It may not "correct" itself at all and still end up with a 10 PE, simply by not going up even while the S&P 500 companies continue to increase earnings. On the other hand, we are pretty decent at picking businesses out of the pile that are great businesses that we can buy at a great price. This, to a degree, is market dependent in the sense that our partner, Mr. Market, is well-known to us to be Bi-Polar and, therefore, almost certain to slip regularly into an emotional state of euphoria or deep depression. And we react accordingly by selling into the euphoric state and buying when he's most depressed. This is our general strategy. Still, we know that Mr. Market is just as capable of getting euphoric or depressed about a specific business as about the market as a whole. Certainly, our dear partner is more susceptible to being depressed about a specific great business when he's depressed in general, but it isn't out of the question that he can be depressed about a great business even while being euphoric in general. In fact, that happens quite a lot and causes us to pay attention to the specific industries within the market. Mr. Market might be entirely depressed about tech stocks even while being euphoric about banking stocks, for example. The result of this is that we, as Rule #1 investors, can expect that there are more great businesses for sale in a depressed market than in an euphoric one; and vice versa, that there are fewer great businesses on sale in a euphoric market than in a depressed one. So, Adrian, had you been watching closely for your specific great businesses to go on sale, it is entirely possible that none of them were on sale for the last five years, or that all of them were. Actually, it's quite likely that many of them were on sale after the Dow got to 7500, but that was before I wrote the book, and you can't be faulted for not acting when you didn't have the information. BUT, now you do, assuming you've actually read Rule #1, and this time you'll be prepared. Don't wait for me or anyone else to tell you what to do. Learn to decide on your own based on these simple principles: 1. Know your business and industry well: that means "do your homework"; 2. Only look at businesses that are durable and can raise prices with inflation: that means they have a big, protective, monopolistic moat;

3. Only invest with people you trust and who share your values: that means, in my case, among other things, that they have a passion and a BAG; 4. Only invest when you know the real value of the business as a business and then only when it's significantly on sale: which means it has a big MOS. If you will follow these principles, it is almost certain that you will make money in the long run. In the short run, if you only do what I just said, you could own something that the market is pricing below what you paid for it. The "short run" can last years and, if you made a mistake, it can last a lifetime. Therefore, in addition to what I said above, I use tools to get in and out with the Big Guys so that I am protected from my own ignorance. I know these tools will cost me some of my profits. I know that I will do better if I am right about the business if I do not use the tools. But I am a chicken and do not trust that I know enough to be right about the future and I, therefore, get out like a big chicken if the big guys are selling off. Thus, I do not have to ride the market down if Mr. Market gets crazy or suddenly sane and has a big sell off. If there is a big sell off, it is being done, by definition of "big", by the big guys -- and then I'm out. I encourage you guys to think similarly, even if it takes away some of the profits.

QUESTION OF THE WEEK: DISCOVERING THE HISTORICAL PE

Determining the historical PE ratio for a business is a bit of an art. Several of you have written in about it, but this email is getting right to a solution to the problem: Question: "Hi Phil Town, when calculating the average PE over a number of years, is it better to calculate using the standard Average calculation, or is it better to use a Mean calculation instead? I ask this because of the overinflated past PE numbers that resulted from the internet boom. These overinflated numbers sometimes occured once or twice over the past 10 year history. So does it really matter to include them in the overall calculation since they might overinflate the Average PE? I think the Mean calculation will smooth the Average out to a more reliable PE." -- Dennis and Lisa Answer: You know, these guys are already way better at this than I am. What I usually do on MSN Money is just look at the PE bars year by year and make a reasonable assumption about what the future might hold based on that. I sort of mentally toss out the really high PE years -- the ones that are way higher than the others. The idea is to guess what the PE could be if the business does what we think it will do.

We're going to use our best estimate of historical PE as a balance against the Rule #1 PE of 2X the estimated growth rate. The only time we're not going to use the Rule #1 PE is when the historical is LOWER. So when you look at Historical PE, look at it with that in mind -- that the only time to use it is when, for some reason, this business does NOT get the PE it should get. Find a reasonable Mean average or take the obvious visual high average (dumping the really high ones) and that's the historical PE for you. It's a rough guess. Don't be too worked up about it. Just be reasonable with the past.

5 Stocks: A Rule #1 Analysis of Jim Jubak's Picks

One way to learn about investing your own money is to do your own analysis on investing advice from the pros. It's kind of fun to do a Rule #1analysis on a list of stocks that some professional has just claimed will be high return investments and find that the results of the analysis show you that the stocks are either highly speculative or way overpriced. And it's even more fun when you discover an occasional wonderful business that's on sale. Jim Jubak writes a column on investing on MSN Money calledJubak's Journal. Today (Dec. 7) he picks five stocks that should do well as the dollar falls in value against other currencies. Let's take a look at the five and see if any of them is a great business that's on sale. I'm going to use Investools to do the analysis because it's quick, but you can do the same thing on MSN or Yahoo. Dynamic Materials (BOOM). They do explosion welding all over the world. 1. Trend: The first thing I want to see is the long term trends on the Big Five Numbers. ROIC is good then bad then good, while sales, earnings, equity and cash are flat to down for years. But then all of them took off in 2004 and they got rid of their debt. So lately this thing looks quite good. I'd better really understand what's driving this sudden growth, because I can't count on the history of the business for predictability. Risky Biz. 2. Valuation: Analysts average 18% for future growth, which, compared with what it's been doing lately, looks quite conservative. Rule #1 PE is 36 but historical PE is 26. A quick look at year by year high and low PEs tells a scary story. This business had high PEs of under 10 for a couple of years and lately is running upwards of 70. I'm going with the historical

average of 26 here, but feeling shaky about valuation. I get a $66 stock that is priced today at $64. But really this thing could be worth a lot more. If I used 24% and a 48 PE - both of which are defendable - I get a value of $200. My gut tells me that this could be a good investment at its current price. If I want to take a shot at it, though, I'm going to have to get good at that industry and probably even have to get good at predicting the future of oil drilling, since that's where these guys do a lot of business. That dries up, so do they, I'm guessing. Since this area doesn't fall within my circle of competence (described in Rule #1) and since I'm not up for the homework, I have to say that I really don't know the value of this business and, therefore, I don't really know if it's at a good price. Probably is, but I just don't know for sure, and guessing is a great way to lose a lot of money. Especially with a business that can get a 7 PE someday. Imagine what that would do to the price? Even with growth at 18%, it puts the value in 2017 at $72. Ouch. General Cable: (BGC): Makes cables for communications networks and utilities worldwide. 1. Trend: This thing is a roller coaster that's been on a nice climb lately, but it shows a historical probability of having a nice crash sometime soon. And ROIC is under the minimum 10% for its whole 10 year history. 2. Valuation: With those trend numbers I couldn't tell you what the long term growth rate would be. Six analysts cover the company, but only one is willing to put a long term growth rate on it at 16%. Brave soul. Using that number with its historical PE of about... well, its historical PE ranges from 2 to 100, so take your best guess. Investools suggests 26. And with that we get a $100 value on a stock selling for $80 that could be worth anywhere from $20 to $200. Who knows. Unless you are an expert at this industry there is no way to put a price on this business other than its break up value (equity) plus something for being in business. Too much of a guess for me to even consider. Middleby (MIDD): Makes restaurant heavy duty cooking equipment worldwide.

1. Trend: This is a very nice trend for a Risky Biz portfolio candidate. Need to understand the Moat here, but something good is happening to these guys that is driving almost all their numbers pretty much straight up from nowhere. 2. Valuation: The long term guesses by four analysts range from 18% to 50% per year EPS growth. This is not so good for us, since it tells us that four experts can disagree pretty massively about the future for MIDD. Still, even the worst case guy is going for 18%. With PE ranging from 7 to 32, we're constrained about the multiple. As much as I'd like to put it at 36, I'm going to keep it under its high. Historical is 20, but that seems way low for a decent grower with good long term Big Five numbers and no debt. Let's use 30. And I get a $112 business selling for $72. Jack up the growth rate a tad and this thing is in MOS range. That makes me think that if I want to get into the restaurant business, this might be a good way to do it. If you like this area you might want to do some homework on this industry and company and tell us if it's looking good for the long term. Could be something we all want to take a longer look at. Worth considering. Pentair (PNR): water treatment equipment worldwide. 1. Trend: Wobbly trends. With equity growing maybe at 10%, an ROIC well below 10% and not so great operating cash flow, this on isn't on my radar screen, even though they may be in a good growth industry. Price would have to be the consideration here. 2. Valuation: Analysts give it a rather solid 12% growth rate, and that with a historical 20 PE combine to produce a $30 value for a stock selling for $34. Gonna have to really understand this one to be able to jack the value up into the $60s. Doubt that I could get it that high even if I really liked it. Not gonna happen. Wabtec aka Westinghouse Air Brake (WAB): Makes stuff for railroad freight and transit cars. 1. Trend: I'm not a fan of the disparity between the sales growth at 5% and the excellent recent growth in

the rest of the Big Five, but this looks to be an up and comer on the increase in rail business that got Buffett into rail stocks like BNI. Could be worth a longer look if you are inclined toward railroads these days, because the recent trends are good with the important exception of sales. What's up with that? You better know or don't go here. 2. Valuation: I think the analyst expected avg. EPS growth rate looks pretty good at 17%, and with a historical PE of 25, we get a fairly conservative value of $64 on a business selling for $36. Hummmmm. This one has my attention because of their improving trends and the big price to value disparity. If I wanted to be in rails, I'd learn enough about this one to know that the sales issue isn't long term, that the sales will catch up with the growth rate of the other three. And if I were satisfied with that and with management, this one looks like a buy right now. But remember to do your homework and to know the industry and get real happy about the durability of these numbers.

Phil Town-Rule #1 Look at DNA

You know that Phil Town would want you all to invest in businesses you understand. I'm a river guide. What I understand well is pretty much limited to burgers and Harleys, but I do like to venture into things that have a lot of potential from time to time. And I get tips from friends. It's the tips from friends thing that gets me sometimes. You know, friends who are insiders someplace or at least they know people. My kid knows her friend whose mom used to work there. That sort of thing. Stuff you can really trust. Right. But still. So here we go on DNA -- Genentech -- which came highly recommended by friends who built a nice life by getting DNA stock before it went public and selling a bit here and there as it went up to $100. Now it's dropped down to $70, and unless Genetech is about to hit a wall, it's looking pretty much like a very good business that is on sale. Here's how I looked it over this morning (and I'm using Investools here, just for time's sake): I got the chart up and noted that it peaked at $100 a couple of years ago and has been drifting down ever since... and is now at $70. Doesn't mean much, except that it's out of favor with the Big Guys. So let's take a quick look at the industry and see how it's been doing in the same time frame. DNA is in the Biotechnology & Drugs industry ($BIOTRX) which, as you can see below, has done pretty well over that two year period, rising from 500 to 650 -- about a 14% per year gain.

That means the issues related to the drop in DNA stock of 16% per year while its industry group is rising 14% a year are internal to Genentech rather than industry wide. Darn. I like to find out that a good business is being hammered unfairly with the rest of its industry. When the industry is doing well and your stock isn't, usually the problem is one of two things: 1. Your stock was way overpriced and it is now being repriced more in tune with its value; or 2. There is a perception among the Big Guys that something is wrong in your business. If it's the latter and the issue is clear to the Big Guys, you'll see a very large drop in the price very quickly. It's not going to take them 2 years to get out. It's going to take them a couple of months. A long price slide like we see at DNA is telling us that whatever is going on is probably not a clear-cut problem and may be just a gathering herd of Big Guy sheep following a leader. And if that's the case, they are going to wake up one day and wonder why DNA is priced so low relative to its value, and then they are going to buy it back up to its value. So let's take a look and see what that value might be. Start with looking at the earnings estimates from analysts. You'll find that on the left menu at MSN Money once you open the main page for DNA.

You'll notice a fun thing: There are 19 pros who are willing to say that they know what the growth of earnings will be over the next 5 years. And you'll notice that they have a pretty substantial difference of opinion: their estimates range from 16% to 41% per year EPS growth. That's a big gap. DNA has been averaging 68% for the last 5 years. And last year it grew its earnings 31%. The average of the analysts is at 25%. We could use that for a starter to get to a value. Plug the trailing twelve months earnings into the calculator ($2.55), stick in the 25% growth rate (since historical is higher than that), use a 50 PE (since historical PE is higher than that), use a 15% discount rate since that's our minimum acceptable rate of return, and hit the button. I get $294 a share as the value of DNA today. It's full MOS is half of that -- $147. It's selling for $70, half the MOS. Hmmmm. Let's do it again using the most cautious analyst's estimate for future growth: 16%. That gives us a 32 PE. Plug it all in and we get a value of $89. A full 50% MOS is $45 and a 20% MOS is $72. And it's selling for $70. Hmmm. Hmmmm. There is a lot of upside in this business right now. If these guys keep hitting their bigger EPS numbers this thing is going to go sailing upward. On the other hand, how much downside is in this? We're getting it somewhat on sale at $70. What that means is that if the most cautious guy is right, in ten years or so the stock will sell for about $360. We bought it at $70. We made 18% a year. Sweet. So there is only the question of understanding the business that we own. In this case, that seems to me to be quite a job. Not impossible, but significant. I'd have to understand the pipeline of DNA products, how those will compete in the long run with Amgen and the regular pharmas. That's a lot to try to learn. Still, it's really like taking on a term paper. A couple of weeks of work would do the job. I'd know by then if I was going to be okay with this industry as one of my areas of expertise. And I'd know by then what the issues are with DNA. And I'd know enough by then to make up my own mind about their future, put that into a number, put that into the calculator, and get a value that I would feel solid about. That's how you do it.